Interest Deductibility and Capital Structure The use of debt has a distinct advantage over financing with stock,
Interest Deductibility and Capital Structure The use of debt has a distinct advantage over financing with stock,
thanks to Congress. The Internal Revenue Code (IRC), written by Con- gress, allows interest paid on debt to be deducted by the paying corpo- ration in determining its taxable income. 4
This deduction represents a form of a government subsidy of financ- ing activities. By allowing interest to be deducted from taxable income, the government is sharing the firm’s cost of debt. To see how this sub- sidy works, compare two firms: Firm U (unlevered) and Firm L (levered). Suppose both have the same $5,000 taxable income before interest and taxes. Firm U is financed entirely with equity, whereas Firm L is financed with $10,000 debt that requires an annual payment of 10% interest. If the tax rate for both firms is 30%, the tax payable and net income to owners are calculated as follows:
Firm L (No Debt) ($10,000 Debt)
Firm U
$5,000 Less: interest expense
Taxable income before taxes and interest
0 1,000 Taxable income before taxes
$4,000 Less: taxes at 30% of taxable income
1,200 Net income to owners
$2,800 By financing its activities with debt, paying interest of $1,000, Firm
L reduces its tax bill by $300. Firm L’s creditors receive $1,000 of income, the government receives $1,200 of income, and the owners receive $2,800. The $300 represents money Firm L does not pay because they are allowed to deduct the $1,000 interest. This reduction in the tax bill is a type of subsidy.
4 Internal Revenue Code (IRC) (1986 Code) Section 163. For individuals, the interest deduction may be subject to limitations [IRC Section 163 (d)].
Capital Structure
If Firm LL (Lots of Leverage) has the same operating earnings and tax rate as Firms U and L, but uses $20,000 of debt (at the 10% interest rate), the taxes payable and net income to owners are as follows:
Firm LL (No Debt) ($10,000 Debt) ($20,000 Debt)
Firm U
Firm L
Taxable income before taxes and interest
$5,000 Less: interest expense
2,000 Taxable income before taxes
$3,000 Less: taxes at 30%
900 Net income to owners
$2,100 Comparing Firm LL to Firm L, we see that creditors’ income (the
interest expense) is $2,000 ($1,000 more than Firm L), taxes are $900 ($300 lower than Firm L’s $1,200 taxes) and the net income to owners $2,100 ($700 lower than Firm L’s net income). If Firm L were to increase its debt financing from $10,000 to $20,000, like Firm LL’s, the total net income to the suppliers of capital—the creditors and owners— is increased $300, from $3,800 to $4,100, determined as follows:
Firm L
Firm LL
($10,000 Debt) ($20,000 Debt)
Income to creditors
Income to owners
The distribution of incomes for Firms U, L, and LL is shown in Exhibit 18.6. In the case of Firm U, 70% of the income goes to owners and 30% goes to the government in the form of taxes. In the case of Firm LL, 42% of the income goes to owners and 18% goes to taxes, with the remaining 40% going to creditors.
Extending this example to different levels of debt financing, a pattern emerges. A summary of the distribution of income to creditors and share- holders (as well as the government’s share) for different levels of debt financing is shown in Exhibit 18.7. We are assuming, for simplicity, that the cost of debt (10%) remains the same for all levels of debt financing. And this would be the case in a perfect market. The government subsidy for debt financing grows as the level of debt financing grows. With increases in the use of debt financing, the creditors’ share of earnings increases and the owners’ and the government’s shares decrease.
FINANCING DECISIONS
EXHIBIT 18.6 Distribution of Income Among Owners, Creditors, and the
Government for Firms U, L and LL
EXHIBIT 18.7 Distribution of Income between Owners, Creditors, and the
Government for Different Levels of Debt Financing, Using a 30% Tax Rate and Assuming 10% Interest on Debt
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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